Whether it is banks’ reluctance to commit to buying and selling bonds, shortages in the securities used as collateral in short-term money markets, or the disproportionate role of heavyweight issuers in the supply of U.S. corporate bonds, dysfunction is everywhere. As the Federal Reserve prepares to raise rates, this is raising questions about how well it can manage the credit creation process, the transmission mechanism through which it pursues its economic goals. It might also mean it is risking financial turmoil.

Bond geeks are decrying illiquidity – the idea that there aren’t enough standing bids or offers in the marketplace for investors to move quickly in or out of large positions. Combine that with the uncertainty that the Federal Open Market Committee has deliberately fostered around the timing of its first rate increase in eight years and you have the prospect of investors having to unwind bets at a big loss. Such risks could in turn further discourage banks and investment managers from putting money into the market.

“There seems to be a conflict between low liquidity in markets requiring more and more predictability and the Fed wanting to have more flexibility,” says Deutsche Bank economist Torsten Slok. The “lack of liquidity could trigger a volatile reaction in fixed income markets as investors re-position for whatever decision the FOMC takes.”

Last month, the Bank for International Settlements noted “signs of increased fragility and divergence of liquidity conditions across different fixed income markets.” The problem, the BIS said, is that “market-making is concentrating in the most liquid securities and deteriorating in the less liquid ones.” In other words, the broker-dealers that commit to buy, sell and hold portfolios of bonds so that institutional money managers can readily trade them in the secondary market aren’t doing so for anything less frequently traded than Treasury securities or large corporate bonds.

That’s a failure of monetary policy: the Fed’s primary goal over the past six years, during which it has bought trillions of dollars in Treasury and mortgage bonds and kept rates near zero, has been to encourage risk-taking in credit markets to drive borrowing and spur investment in economic projects.

Until now, the Fed could say that at least aggregate corporate borrowing has surged as the biggest companies have taken advantage of record-low rates – exemplified by Verizon Communications’s record-breaking $49 billion offering in 2013. But much of that funding was used to retire old, more expensive debt rather than to finance new risk-taking investments. As for small firms, they haven’t had a look in.

What’s more, even the big players’ future issuance could dry up after the Fed tightens policy if illiquidity causes rates on corporate bond yields to spike much higher than otherwise warranted.

Meanwhile, the $2.6 trillion repurchase securities, or repo, market in which banks, money-market funds and other institutions lend and borrow money over short periods is beset by shortages of the high-quality securities that they use as collateral. A lack of Treasury securities is creating bigger swings in short-term rates, making it more expensive and unpredictable for institutions that need overnight finance or which must put excess cash to work. Some believe the problem will force the Fed to expand the quota for a special “reverse repo” contract it designed to drain funds from the market and achieve its interest rate target after it is increased. The central bank has been reluctant to increase the quota for fear of sucking up funds that should otherwise be going to private borrowers such as companies. But it may have no choice.

Why, after six years of unprecedented policy efforts to induce financial risk-taking, are these markets unwilling to engage in it?

Many Wall Street bankers blame the tougher post-crisis regulations. But the point of those rules was precisely to reduce the excess risk-taking that led to the crisis. You can’t have your cake and eat it too.

Competition from high-speed trading firms, whose proprietary programs exploit differences between prices more readily than can traditional broker-dealers, has also discouraged the latter from providing liquidity by making it less profitable. Having “HFT” firms provide the liquidity instead isn’t inherently a problem except that they are inclined to withdraw it at vital moments, creating profound volatility and “flash crash” incidents.

Then there’s central bank policy itself. Although the last “quantitative easing” program ended in October, the Fed still regularly buys Treasurys and government-backed mortgages to keep a steady balance sheet as existing holdings mature. This privileging of government-backed securities over private debt means that as the European Central Bank now conducts its own government bond-buying program, money fleeing rock-bottom eurozone yields continues to disproportionately seek Treasurys and housing agency debt.

Ideally, the solution would be to encourage decentralized liquidity, creating efficient peer-to-peer marketplaces where fund managers can trade directly without intermediating market-makers. In a bid to encourage this, asset manager BlackRock Inc. has proposed standardizing corporate bonds structures to narrow the array of instruments and maturities and thus widen the pool of substitutable securities for fund managers to trade with each other. In the future also, real-time payment and settlement technologies based on transparent digital ledgers like that used by bitcoin might one day draw more investors into a decentralized marketplace by reducing the risk of counterparty failure.

Unfortunately, the Fed doesn’t have time to wait for such innovations. If economic conditions demand that it raise rates this year it will simply have to contend with the existing, broken model.

Postponing action for fear of an adverse reaction is not an option. That would deepen the dysfunction and make the eventual exit even harder. The Fed may have no choice but to throw a few bond investors under the bus.